Making Sense of China's Future

by: StreetAuthority

By David Sterman

Sometimes, investors just need an excuse to sell. If they feel like worrying, there are always an ample amount of things to worry about. A few months ago, Greece was the concern du jour. Even though it's a tiny economy, and has almost zero trade with the U.S. outside of tourism and feta cheese, it still became the catalyst for billions in lost market value.

Now, the world's fastest-growing (and likely eventually largest) economy, China, is spooking the market down to further lows. The S&P 500 hovers perilously above 1,000, right where it sat 10 months ago. The concern: An overheated Chinese economy is set to slow -- sharply. But it's hard to see how China can come in for a hard landing with so many positive drivers still in place.

Let's look at the facts. Up until now, China has been able to maintain very strong GDP growth rates -- around 8% in 2008 when the rest of the world was seeing an economic contraction, and closer to 10% as the global economy rebounded. That kind of growth is bound to incite talk of a bubble. And sure enough, housing prices in major cities like Beijing, Shanghai and Shenzen have soared. Homeowners in those areas may soon find they vastly overpaid for their flats. But crucially, Chinese investors typically must come down with very large down payments, up to 30% to 50%, so very few will end up "underwater" and foreclosed upon.

But in many other respects, Chinese policy planners have already been applying the brakes, steadily reducing the chance of overheating. Just five years ago, banks would lend to almost any company that was looking to hop on the export machine. Now, those banks are being told to cull the herd and stop encouraging too many new businesses.

For example, nearly 80 Chinese companies sprang up to make glysophate, the generic equivalent of Monsanto's (NYSE: MON) Round-up herbicide. But the world was soon awash in the stuff, and many of the glysophate makers began to operate at a loss. Now, there are just 15 firms in China making glysophate (which, by the way, is good news for Monsanto as well, as lower output means higher prices).

Equally important, China developed a $586 billion stimulus program in 2008 to help build out transportation links and other infrastructure in its economically-underdeveloped interior. Just as was the case with the building of our interstate system, that should lead to sustained economic growth in the interior as demand grows for fast food joints, Wal-Mart (NYSE: WMT) stores, professional services like architects, and dozens of other types of businesses.

The greatest concern for China has centered around labor costs, which had been among the lowest in the world. And as we saw in Japan in the 1970's, and then Korea more recently, that's simply unsustainable. But Japan and Korea smoothly morphed into more broad-based economies that no longer relied on cheap labor.

There's a good chance that China's GDP falls by half to 5% or even 4%. But in some respects, that's more desirable than 10% GDP growth. The lower growth rate allows the country's central planners to more adeptly control the economic policy levers that can modulate growth to a target level. Chinese planners had previously been fixated on squeezing out the highest growth rates. Now, they're fixated on social harmony, which means they simply want to avoid any wrenching economic moves that would trigger social unrest.

With nearly $1 trillion in foreign currency reserves, China has ample capacity to stimulate or cool its economy as it pleases. If it needs to stimulate, then efforts to boost domestic consumption will be the focus. Gone are the days when China looked to simply export its way out of any problems. And that's a good thing.

Action to Take -- Share prices around the world have been slumping, due in part to fears of a China contraction. Chinese stocks in particular are trading well off their highs. China's Shanghai Composite Index has fallen from 3,250 at the start of the year to a recent 2,475. And as we've noted in these pages, many strong domestic-focused China plays are getting no love. Deer Consumer Products (Nasdaq: DEER), Perfect World (Nasdaq: PWRD), and many others in the table below sport single-digit forward P/Es. Looking at that metric, you'd never think we're talking about an economy that is poised to soon overtake Japan and Germany and become the world's second-largest economy.

Disclosure: No positions